A Formal Economic Theory for Happiness Studies: A Solution to the Happiness-Income Puzzle ⁄

This paper develops a formal and rigorous economic theory that provides a micro foundation for studying happiness from the perspectives of social happiness maximization and pursuit of individual self-interest, and can be especially used to study a paradox at the heart of our lives: average happiness levels do not increase as countries grow wealthier. The theory, which takes into account both income factors and non-income factors, integrates the existing reference group theory and the \omitted variables theory, and identifles a fundamental con∞ict between individual and social welfare/happiness. We show that, up to a critical income level that is positively related to non-material status, increase in income enhances happiness. Once the critical income level is achieved, increase in income cannot increase social happiness and in fact, somewhat surprising, social happiness actually decreases, resulting in Pareto ine‐cient outcomes. A policy implication of our model is that government should promote income and non-income status in a balanced way by increasing public expenses on non-material wants such as mental status, family life, health, basic human rights, etc. when national income becomes relatively large. Our empirical results conflrm the implication and are robust across the countries under consideration.